529 Distribution to match 2023 scholarship went thru in January 2, 2024

[nmepxe]

With these numbers, it makes more sense to claim AOTC, right?

[Hal_Al · Accepted solution]

Q. With these numbers, it makes more sense to claim AOTC, right?

A.  Good question. Maybe not.  It depends on the 529 plan earnings.

Using an example, let's say $30,000 of that $45,000 distribution was earnings. 12.56% x $30,000 = $3768 taxable income. Not using the AOTC results in about $1100 taxable income ($4000 more QEE allocates to the distribution).  You're only saving about $100, in tax, by using the AOTC.   You only get to use the AOTC 4 times in the student's undergrad years.  If this situation continues for 3 more years, you may not see much benefit from the AOTC.  But, if that's all you can get, there's no need to save the AOTC for later. It's better if the parents can use it.

What if you use the Lifetime Learning Credit (LLC) instead. $6000 more will be allocated to the tuition credit, meaning $6000 less goes to the 529 distribution.  $39,350 -6000 = 33,350.  33,350 / 45,000 = 74.1% . 25.9% of the 529 earnings portion is taxable. 25.9% x $30,000 = $7767 taxable income.  Even if taxed at 22%, the tax should be wiped put by  the LLC (maximum $2000).

You want to consider using the download version of TurboTax, rather than the online versions. You can do multiple trial returns to see which gives you the best result. 

[nmepxe]

Earnings from the $45K distribution are less than $2K because we withdrew from less aggressive/mostly fixed-income accounts.  I didn't know I could withdraw from his accounts with big earnings and still avoid paying taxes. 

With such small earnings from the distribution does it still make sense to claim AOTC or LLC?

[Hal_Al · Accepted solution]

Q. With such small earnings from the distribution does it still make sense to claim AOTC or LLC?

A.  Probably not. 12.5% of $2000 = $250 taxable income = about $25 tax.  Shifting $4000 QEE to the distribution makes it even less. 

[nmepxe]

Thank you so much for all these pieces of information. I learned and understood so much!

[Hal_Al]

You brought up an issue that I'm not sure "how it works". 

You said "Earnings are low because we withdrew from less aggressive/mostly fixed-income accounts."

I would think that earnings are prorated based on the total balance in your overall 529 plan and not just the earnings in the individual investment (account) that you withdrew from. You show probably verify that with the plan administrator. Normally the 1099-R would answer that question, but you're not getting one.  Please let me know what you find out.

Edited 1/6/24: Here's one reference that agrees, with me. 

 https://www.savingforcollege.com/article/can-i-withdraw-contributions-from-a-529-plan-without-penalt....

It says, in part, "The basis portion and earnings portions are calculated using the following formula:

(Total Contributions / Value of 529 Plan Account) * Amount of Distribution = Basis Portion

Amount of Distribution – Basis Portion = Earnings Portion"

[nmepxe]

I made several withdrawals from several investment accounts. Two were disbursed in 2023.  One withdrawal (payment made to us, not our son) was used to reimburse the out-of-pocket payment we made. Another one was disbursed on Dec 29, 2023, a check written to our son, from a fixed-income account, to cover the scholarship my son received.

I'll know how the plan treats the earnings because we'll receive 1099-R for those two withdrawals. Will we 2 separate 1099-Rs, one for us and one for our son? 

[Hal_Al]

Q. Will we get 2 separate 1099-Qs, one for us and one for our son? 

A. Yes, since there were two different recipients (with two different SS#'s). 

[nmepxe]

Claiming LLC or AOTC gives my son a full refund of the $64 tax deduction from his lifeguarding job, but he ended up owing almost $300 in state taxes (Virginia).  Did I do something wrong?

I instead entered his QTP earnings using this formula  (scholarship amount / total distribution) x total earnings from distribution. Using this he gets his $64 refund and $0 state tax. Is this the way to do it?

[Hal_Al]

Q. Claiming LLC or AOTC gives my son a full refund of the $64 tax deduction from his lifeguarding job, but he ended up owing almost $300 in state taxes (Virginia). Did I do something wrong?
A. No. A federal tax credit doesn't help you on the state return. The taxable income from the scholarship and/or 529 earnings will transfer to the state return. The VA standard deduction is much less than the federal. Although $300 sounds like a lot.

Q. I instead entered his QTP earnings using this formula (scholarship amount / total distribution) x total earnings from distribution. Using this he gets his $64 refund and $0 state tax. Is this the way to do it?
A. No. The formula is: non-qualified distribution amount / total distribution x earnings from distribution. But TT does that calculation. I don't know how you would even enter a manual calculation, except directly on the worksheets.

[nmepxe]

My son's 1099-Q

Total Distribution: $45,000

Earnings from distribution:  $709

My 1099-Q

Total Distribution: $15844

Earnings: $5691

1098-T

Box 1: $41844

Box 5: $26000

I don't plan to put numbers from my 1099-Q because the entire amount was used to pay for qualified 529 educational expenses (Room and Board, tuition fees, etc).

Of the $45,000 distribution, only $26,000 is matched by the scholarship paid towards tuition. $19,000 was excess distribution not used for educational expenses in 2023.

[Hal_Al]

Q. I don't plan to put numbers from my 1099-Q because the entire amount was used to pay for qualified 529 educational expenses (Room and Board, tuition fees, etc).

A. Yes. 

Q. $19,000 was excess distribution not used for educational expenses in 2023.

A. I'm not sure how you got that number, but it's academic.  With only $709 of earnings, in box 2 of the 1099-Q, the taxable amount is negligible.  $709 at the most, $300 with a $19,000 non qualified distribution. Without even declaring some of his scholarship as taxable, there's only $709 (or less) of income. If  that plus his $2500 wages is his only income, he doesn't even need to file a tax return, unless he needs a refund of withholding. Because of the scholarship, the penalty exception applies. 

[nmepxe]

$45,000 less $26,000 (scholarship, used to pay for tuition fee) = $19,000 (excess distribution), so we're paying taxes and penalty earnings part of the $19000 ($19000/$45000) which is $300.  I think he ends up paying just the penalty of $30, that's why his refund is showing up as $34 ($64 taxes deducted less $30 penalty).

I need to file taxes for him so he can claim back $34 deducted from his paycheck for lifeguarding.

Using this approach, we can still claim his as dependent right?

Again, thank you so much for all the help.

[Hal_Al]

Q. Using this approach, we can still claim his as dependent right?

A. Yes. 

[nmepxe]

RE: $45,000 less $26,000 (scholarship, used to pay for tuition fee) = $19,000 (excess distribution), so we're paying taxes and penalty earnings part of the $19000 ($19000/$45000) which is $300.  I think he ends up paying just the penalty of $30, that's why his refund is showing up as $34 ($64 taxes deducted less $30 penalty).

The entire earnings ($709) on the $45K distribution is taxable, but only $299 (the earnings on distribution not used to pay for educational expenses) has a 10% penalty.